Chapter 27. Income Taxation of Trusts and Estates. Eugene Willis, William H. Hoffman, Jr., David M. Maloney and William A. Raabe

Transcription

1 Chapter 27 Income Taxation of Trusts and Estates Eugene Willis, William H. Hoffman, Jr., David M. Maloney and William A. Raabe Copyright 2004 South-Western/Thomson Learning

2 Using Trusts (slide 1 of 5) Life Insurance Trust Holds life insurance policies on the insured Removes proceeds of of policies from gross estate (if irrevocable trust) Safeguards against receipt of of proceeds by young or or inexperienced beneficiary C27-2

3 Using Trusts (slide 2 of 5) Living (revocable) Trust Holds all assets owned by an individual Simplifies probate, since beneficiaries are established for trust Provides privacy for asset transfers Simplifies asset management C27-3

4 Using Trusts (slide 3 of 5) Trust for minors Provides funds for college education Shifts income to to lower-bracket taxpayers Allows parents to to retain some control over children s use of of assets C27-4

5 Using Trusts (slide 4 of 5) Blind trust Holds assets of of grantor without his/her input or or influence (e.g., while grantor holds political office or or some other sensitive position) Retirement trust A special tax-exempt trust that manages asset contributions under a qualified retirement plan C27-5

6 Using Trusts (slide 5 of 5) Alimony trust Manages assets of of an ex-spouse and ensures they will be transferred on a prescribed schedule to to named beneficiaries Liquidation trust Manages assets and final dissolution of of a corporation undergoing a complete liquidation C27-6

7 Structure of Typical Trust C27-7

8 Structure of Typical Estate C27-8

9 What Is A Trust? Not defined in Code Usually refers to to an arrangement created by a will or or by inter vivos (lifetime) declaration Trustee takes title to to property for purpose of of protecting or or conserving it it for beneficiary C27-9

10 What Is An Estate? Created upon the death of every individual Collects and conserves an individual s assets, satisfies all liabilities, and distributes the remaining assets to to heirs C27-10

11 Filing Requirements Fiduciary must file a Form 1041, U.S. Income Tax Return For Estates and Trusts, in the following situations: For an estate with gross income of of $600 or or more For a trust that either has any taxable income or, if if no taxable income, has gross income of of $600 or or more Due date is is 15th day of fourth month following year-end C27-11

12 Tax Accounting Periods, Methods, And Payments (slide 1 of 2) Tax year Estates can use calendar year or or fiscal year Trusts must use a calendar year C27-12

13 Tax Accounting Periods, Methods, And Payments (slide 2 of 2) Estimated tax payments Trusts and estates are required to to make quarterly estimated tax payments using same schedule as as individuals Applies to to estates and grantor trusts only for for tax tax years ending two or or more years after date of of decedent s death Charitable trusts and private foundations are are exempt from making estimated tax tax payments C27-13

14 Tax Rates for Estates and Trusts Taxable Income Tax is: is: But Not Of Of Amount Over Over Over $ $1,900 15% $-0-1,900 4,500 $ % 1,900 4,500 6,850 $ % 4,500 6,850 9,350 $1, % 6,850 9, $2, % 9,350 Note: tax tax on on net net long-term capital gains of of fiduciary is is limited to to 20% C27-14

15 Personal Exemptions Estates $600 Simple trusts(generally) $300 All other trusts (primarily complex trusts) $100 C27-15

16 Alternative Minimum Tax May apply to to an estate or or trust in in any year AMTI calculation is is generally the the same as as for for individuals Annual exemption = $22,500, with phaseout Rate = 26% on on first $175,000 AMTI, 28% thereafter C27-16

17 Taxable Income of Trusts, Estates and Beneficiaries 1.Determine Entity Accounting Income 2.Determine Entity Taxable Income Before the Distribution Deduction 3.Compute Distributable Net Income (DNI) and the Distribution Deduction 4.Compute Entity Taxable Income (Step 2 less the deduction determined in in Step 3) 3) 5.Allocate Distributable Net Income, and its character, to to the Beneficiaries. Use the Tier system, if if necessary. C27-17

18 Entity Accounting Income Accounting income is is based on the controlling document Either the document or or state law determines whether amounts are allocated to to corpus or or current income If If the entity distributes income currently, that income should generally correspond to to accounting income C27-18

19 Common Allocations: Income or Corpus Allocable to to Income -Ordinary and and operating net net income from from trust trust assets -Interest, dividend, rent, rent, and and royalty income -Stock dividends -One-half of of fiduciary fees/ fees/ commissions Allocable to to Corpus -Depreciation on on business assets -Casualty gain/loss on on income-producing assets -Insurance recoveries on on income-producing assets -Capital gain/loss on on investment assets -Stock splits -One-half of of fiduciary fees/ fees/ commissions C27-19

20 Taxation Of Estates And Trusts (slide 1 of 2) Generally, estates and trusts act as conduits for income received, and taxation is is at beneficiary level This is is codified through allowance of of a distribution deduction C27-20

21 Taxation Of Estates And Trusts Exceptions: (slide 2 of 2) Complex trusts accumulate income for specified times (e.g., until beneficiary is is age 30) Estates are not always required to to make current distributions In these cases, or other cases where the entity is is not required to distribute current income, the entity itself is is taxed C27-21

22 Property Distributions (slide 1 of 2) Generally, entity does not recognize gain Beneficiary takes same basis in in asset as as it it had in in the estate or or trust Distribution absorbs distributable net income (DNI) and qualifies for a distribution deduction to to extent of of the lesser of: Basis to to beneficiary FMV on on date of of distribution C27-22

23 Property Distributions (slide 2 of 2) Property distributions (cont d) Trustee or or executor can elect to to recognize gains and losses on assets distributed in in kind Beneficiary s basis in in asset would be be FMV Distribution absorbs distributable net net income (DNI) and qualifies for for a distribution deduction equal to to FMV on on date of of distribution C27-23

24 Deductions Allowed (slide 1 of 3) Deductions are allowed for ordinary and necessary expenses for: A trade or or business Production of of income 2% of of AGI floor applies to to many 212 expenses Management, conservation, or or maintenance of of property Determination, collection, or or refund of of any tax C27-24

25 Deductions Allowed (slide 2 of 3) Other deductions No No deduction is is allowed for for expenses related to to the the production or or collection of of tax-exempt income Cost recovery deductions are are allocated proportionately to to the the recipients of of accounting income Deductions are are allowed for for casualty or or theft losses and NOLs Wash sale and related party rules apply C27-25

26 Deductions Allowed (slide 3 of 3) Other deductions (cont d) Charitable contribution deduction is is allowed to to the extent of of amounts included in in gross income for the year Deemed to to be be made proportionately from each of of the the income elements of of entity accounting income C27-26

27 Distributable Net Income (slide 1 of 3) Entity is is allowed a deduction for distributions to beneficiaries Distributable net income (DNI) is is used to to compute the amount of of the deduction Maximum amount beneficiaries pay tax tax on on The The character of of income in in DNI DNI is is preserved to to the the beneficiaries Maximum amount of of distribution deduction C27-27

28 Distributable Net Income (slide 2 of 3) Calculating DNI Step 1: 1: Determine entity s taxable income before the distribution deduction Includes all all of of entity s income, deductions, gains, losses and exemption C27-28

29 Distributable Net Income (slide 3 of 3) Calculating DNI (cont d) Step 2: 2: Make the following adjustments to to entity s taxable income to to determine distributable net income: Add back: Personal exemption Net Net tax-exempt interest Net Net capital losses Subtract net net capital gains allocable to to corpus C27-29

30 Distribution Deduction For estates and complex trusts, distribution deduction is is the lesser of: Deductible portion of of DNI, or or The taxable amount actually distributed For a simple trust, full distribution is is always assumed C27-30

31 Entity Taxable Income Entity taxable income is is calculated as follows: Entity taxable income before the the distribution deduction Less: Distribution deduction Entity taxable income C27-31

32 Allocation Of DNI (slide 1 of 6) Each type of DNI must be allocated proportionately to income beneficiaries This prevents manipulation of of tax liabilities by assigning, for example, tax-exempt income to to high bracket taxpayers, and taxable income to to low bracket taxpayers C27-32

33 Allocation Of DNI (slide 2 of 6) Amount taxable to beneficiaries For a simple trust DNI is is the the maximum taxable amount May be be less if if DNI includes tax-exempt interest If If more than one income beneficiary, apportion elements of of DNI ratably C27-33

34 Allocation Of DNI (slide 3 of 6) Amount taxable to beneficiaries (cont d) For estates and complex trusts Use a two-tier system Income required to to be be distributed is is categorized as as a firsttietier distribution All All other other amounts properly paid, paid, credited or or required to to be be first- distributed are are second-tier distributions C27-34

35 Allocation Of DNI (slide 4 of 6) Amount taxable to beneficiaries (cont d) If If only first-tier distributions are made and those amounts exceed DNI, use the following formula to to allocate DNI among beneficiaries First-tier dist. to to beneficiary X DNI = Beneficiary s First-tier dist. to to all all beneficiaries Share of of DNI C27-35

36 Allocation Of DNI (slide 5 of 6) Amount taxable to beneficiaries (cont d) If If first and second-tier distributions are made and first-tier distributions exceed DNI, use the previous formula to to allocate first-tier distributions Second-tier distributions are not taxed since all DNI has been allocated C27-36

37 Allocation Of DNI (slide 6 of 6) Amount taxable to to beneficiaries (cont d) If If first and second-tier distributions are are made and firsttier distributions do do not exceed DNI, use the the following formula to to allocate DNI among beneficiaries 2nd-tier dist. dist. to to beneficiary X 2nd-tier dist. dist. to to all all beneficiaries Remaining DNI DNI = Beneficiary s share of of DNI C27-37

38 Character of Income Various classes of income retain their character and flow through to beneficiaries If If all all DNI is is distributed and there are are multiple beneficiaries, must allocate various classes of of income Distributions are are treated as as consisting of of the the same same proportion as as the the items that that enter enter into into the the computation of of DNI DNI C27-38

39 Trust Taxation Example (slide 1 of 9) The Alto Family Trust has the the following income and expenses: Interest income $8,000 Tax-exempt income $6,000 Capital gain income $4,000 Fiduciaries fees $2,000 The trust agreement allocates fiduciaries fees to to trust income. Capital gains are are allocated to to trust corpus. C27-39

40 Trust Taxation Example (slide 2 of 9) Accounting income is is as as follows and is is distributed to to Sue, the the sole beneficiary, at at the the end of of the the year: Interest income $ 8,000 Tax-exempt income 6,000 Fiduciaries fees (2000) Accounting income $12,000 C27-40

41 Trust Taxation Example (slide 3 of 9) Fiduciary fees are are allocated between interest income and taxexempt income before calculating trust taxable income: Interest income x Fees =$ =$ 8,000 x$2,000 = $1,143 Total income $14,000 Tax-exempt inc. x Fees =$ =$ 6,000 x$2,000 = $ 857 Total income $14,000 C27-41

42 Trust Taxation Example (slide 4 of 9) Taxable income of of the the trust, before the the distribution deduction, is is as as follows: Capital gain $ 4,000 Interest income 8,000 Less: fiduciaries fees related to to interest income (1,143) Less: exemption (( 300) Taxable income before distribution deduction $10,557 Net tax tax exempt income is is $6,000 less $857, or or $5,143. C27-42

43 Trust Taxation Example (slide 5 of 9) Calculate Distributable Net Net Income (DNI) and and the the distribution deduction as as follows: DNI: DNI: Taxable income before DNI DNI $10,557 Plus: Plus: Exemption Plus: Plus: Tax-exempt income (total) 6,000 Net Net of: of: Expenses allocated to to tax-exempt income (( 857) 857) Less: Capital gains allocated to to corpus (( 4,000) DNI DNI $12,000 In In this this case, case, since since no no expenses were were allocated to to corpus, DNI DNI is isthe amount actually distributed to to the the beneficiary. C27-43

44 Trust Taxation Example (slide 6 of 9) Distribution Deduction The distribution deduction is is the the lesser of of the the amount actually distributed ($12,000) or or DNI net net of of tax-exempt income (less expenses): DNI $12,000 Less: tax-exempt income (( 6,000) Plus: expenses related to to tax-exempt income 857 Distribution deduction $ 6,857 C27-44

45 Trust Taxation Example (slide 7 of 9) Determine trust taxable income after distribution deduction Taxable income before distribution deduction $10,557 Distribution deduction (( 6,857) Taxable income $ 3,700 Note: tax tax is is limited to to 20% since income is is from capital gains C27-45

46 Trust Taxation Example (slide 8 of 9) Allocate DNI and its its character to to the the beneficiaries. DNI to to Sue is is $12,000, consisting of of the the following: InterestTax-Exempt Income Income Total Gross income $8,000 $6,000 $14,000 Allocable fees 1, ,000 Net income, per category $6,857 $5,143 $12,000 C27-46

47 Trust Taxation Example (slide 9 of 9) Sue received a distribution of $12,000 from the trust. She pays tax on $6,857, which corresponds to tax on trust s $8,000 of interest income, and a deduction for a portion of the trustee s fees. She lost deductions of $857 for fees allocated to taxexempt income. C27-47

48 If If you you have any any comments or or suggestions concerning this this PowerPoint Presentation for for West's Federal Taxation, please contact: Dr. Dr. Donald R. R. Trippeer, CPA Colorado State University-Pueblo C27-48